Costs and RevenueHL ONLY

Standard Level

• 5.2.2 Page 630 & 631• 5.2.3 Page 632 Question b & c only

Learning Objectives

HL - To be able to distinguish between cost centres and profit centres and analyse their value

HL - Analyse product viability using contribution analysis

HL - To know why contribution costing is important

Cost Centre Definition• A department or section of an

organisation to which specific costs can be allocated

Example- In a hotel – the restaurant, reception etc

Profit Centre Definition• A division or department of a company that

has been given authority to run itself within the business with its own profit and loss account

• A profit centre must be able to generate revenue, as well as be a centre for the allocation of costs

Examples- Each branch of a chain of shops

Use of Cost & Profit Centres• Accounting - Better analysis of individual

performances & speedier corrective action

• Organisational – Identify which areas are working well and improve decision making

• Motivational – Encourages middle managers to make their division the most profitable

Establishing Cost & Profit Centres

• Vary according to circumstances• May be…– A product – A group of machines– A department– A location – A person

• The choice must be appropriate to the firm

Summary• A cost centre is an area of a business where costs stem from and can easily be recorded (i.e. a

department or a person where costs can be identified as being incurred). These costs include wages and salaries, raw materials and capital expenditure (e.g. machinery).

Cost centres are used for several reasons:– Allowing the business to see which departments and people are spending the most money.– To see if the departments and people are generating enough benefits for the business with the money

that they spend.– Direct costs (i.e. those costs which are incurred directly as a result of production) are easy to allocate to

cost centres, but indirect costs (e.g. rent, rates, loan repayments, etc) are far more difficult to allocate to a specific cost centre.

• A profit centre is an area of a business where revenue can be identified as being earned, (and, hopefully, profit will be made).

• Profit centres generally include different product lines and retail outlets, and they are frequently used by businesses which are large and diversified. They allow a business to see which parts of the business and which products generate the most revenue.

The main reasons for using cost-centres include:– Loss-making departments of the business and loss-making products can be easily identified.– Each profit centre can be viewed as operating independently and this can lead to higher levels of

motivation amongst the staff in each profit centre.– Overall, the use of cost centres and profit centres allows a business to exercise a degree of financial

control over its operations, and to monitor the efficiency and profitability of its various departments and product-lines.

Contributing costing approach

• Contribution costing – costing method that only allocates direct costs to cost/profit centres not overhead costs

• Contribution costing solves the problem of how to divide overhead costs between products, the method concentrates on two very important concepts1. Marginal cost of producing an extra unit2. Contribution to fixed costs and profit

Contribution costing and decision making

Novel Text

$000

Sales Revenue 50 100

Direct Materials 15 35

Direct Labour 20 50

Other Direct Costs 10 5

Total Marginal Cost 45 90

Contribution 5 10

Avoids allocating overhead costs but they are not completely ignoredNeeded to calculate profit and loss

Total contribution is $15000, if total overheads were $12000 then

Profit = contribution – overheads Therefore….profit is

Multi-product firms – assessing viability of each product

• Where more than one product / service is being provided, contribution costing shows managers which product / service is making the greatest / least contribution to overheads and profit

• If costs were evenly distributed a manager may discontinue a product / service that was actually making money

Should a business accept a contract or a purchase offer at below full cost?

• If a firm has spare capacity OR if it is trying to enter a new market segment, then marginal costing assists managers in deciding whether to accept an order at below full cost

• May have long term profits in some cases because– Fixed costs are being paid anyway– If extra costs contribution can be earned, profits

will increase